Depreciation is an accounting concept which aims to reflect the change in the value of the asset inline with standard wear and tear of the asset. The book value of investment properties like any capital asset declines over time to reflect its use.
There is a lot of confusion for property investors reading the depreciation schedule to understand what have and have not been included their deduction. The use of depreciation in the tax return can result in negative or positive gearing of the asset depending on income.
In the simplest form the property can be separated into fixed assets (the building) and fixtures or items that does not constitute the structure of the building but nonetheless are part of the property (plant and equipment).
Division 40 – Plant and Equipment
Plant and equipment is catch all term for loose items in the investment property that does not form the structure nature of the property. Examples of items included here are:
- Carpets / Timber Floors
- Blinds
- Kitchen appliances / Carpentry
- Toilet fixtures (toilets, bathrooms)
Division 40 Depreciation Rate
The common theme here is these are items which are easily removed from the property. After 9 May 2017, the tax office changed the rules so new owners cannot claim depreciation under division 40 to existing assets if it were not used for taxable purpose (investment) prior to 2017.
What this means is that owners were able to claim costs incurred by the prior owner i.e not resetting of the cost base after the transaction. After May 2017, owners can only claim the costs they added as part of their ownership of the property.
There are two methods items classified under Division 40 Plan And Equipment can be depreicated.
- Effective life – There is a pre-set list of items and the rate of depreciation set by ATO based on the quality and the likely life usage of said items. The ultimate value of annual depreciation is based on the effective life the item.
- Diminishing Value method – The depreciation rate is based on the the asset’s base value.
Diminishing Value Formula (after May 2016)
Base Value x Days Held / 365 x 150% / Asset’s Effective Life
The goal of the diminishing value formula assumes that the decline in value each year is constant rate of amount not written off so overtime the decline value is progressively smaller.
It is important to that whichever method above is chosen that the investor sticks to it. It cannot be changed year on year depending on what is the most favourable outcome.
Division 43 – Capital Works Allowance
Capital works allowance includes expenditure incurred in the construction of the asset. These are costs incurred by the developer to build the structure shell of the property like basement, walls and floors.
This means this reflect the actual cost of building the structural elements of the property and excludes the following:
- Land
- Amount spent on land prior to construction
- Civil works surrounding the asset but not integral to the construction it self
- Soft landscaping around the asset
- Demolition of the previous building on the land
After completion, the structural component of the renovation is also included under this section.
Division 43 Depreciation Rate
There are 2 forms of deduction which can be claimed if the building is built after September 1987 and is an income producing property.
- 2.5% Per annum
- 4% each year depending on the classification of the property’s use and construction start date
From a tax perspective there isn’t a distinction between residential or commercial real estate, the concept applies to the whole asset class.
On a like for like basis given the land values make up a higher component of the development cost with only slight variation in other costs (construction, consultant etc) in Sydney relative to Melbourne and Brisbane you would expect the Division 43 depreciation amount to be a smaller component relative to total cost.